April 8, 2016

By Steve Blumenthal

“The Fed may succeed in stretching this cycle until 2017.  But sooner or later it will have to grasp the nettle, and then we will discover how much monetary pain can be taken by a dollarized global economy with post-QE pathologies and total debt ratios some 36pc of GDP higher than in 2008.

So enjoy tactical rallies if you dare.  But seven years into a profitless bull market is not a time for greed.”

Ambrose Evans-Pritchard

In my view, the bet today comes down to this: you believe the Fed can hold the market up (aka “the Fed Put”), you believe politicians can accomplish structural reform and you believe that the same holds true in Europe, China and Japan.  Essentially, “whatever it takes” wins.  Alternatively, you believe that extremely high equity market valuations matter, excessive debt is problematic and that it is ultimately impossible for central bankers, try as they might, to repeal economic business cycles.

[drizzle]Over the last four plus years, any whiff of higher rates has put the market into a tail spin.  All periods have been followed by more dovish Fed comments.  For now it remains “all ‘bout that Fed.”  My best guess is that it will be wage and core inflation that forces Fed’s hand.  To that there are some stirrings but nothing major on the inflation front to fear just yet.  But before that takes flight, keep in mind that the Fed believes interest rates should be 1½% higher today.  The systematic imbalances are plenty.  The tipping point may likely be higher rates.

At the beginning of every month, I like to look at the most recent month-end valuations.  It gives me some sense of just how much risk is embedded in the markets and also a good feel for what the probable 10-year annualized forward returns are likely to be.

I mentioned in last week’s piece that the valuation numbers would likely come in higher and boy, did they!  Median price-to-earnings ratio (my favorite measure) came in at 22.6.  We sit at a higher level than the market peak in 2007.

For now, we collectively bow our heads to the Fed – and the ECB, JCB and CCB.  But, as is taught in the world’s top business schools, valuations do matter.  They are a powerful and reliable determinant of long-term investment returns.

Warren Buffett is famous for saying his family loves hamburgers and when they are expensive to buy, they weep, but when they are inexpensive to buy, they sing the Hallelujah Chorus.  What he is saying is that investors should think about the market the same way.  You’ll find his favorite valuation measure below.  Hint: “PPB” pretty pricey burgers.

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So this week, let’s look at valuation’s measures, take a sober look at margin debt and I share a short and fun clip that explains the Panama Papers.  I think you’ll love it.

Also, as a quick aside, I was interviewed by Gregg Greenberg on TheStreet.com this week.  I talked about gold and I shared what we are seeing in our tactical work (to view the short interview, click on the picture).


Ok, grab a coffee and let’s take a look at current valuations and margin debt.

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Included in this week’s On My Radar:

  • Valuations – A Powerful and Reliable Determinant of Long-Term Investment Returns
  • Margin Debt – This Indicator Suggests Caution
  • The Panama Papers
  • Trade Signals –  Steady as She Goes

Valuations – A Powerful and Reliable Determinant of Long-Term Investment Returns

Let’s start with median price-to-earnings ratios (P/E) and then take a quick run through of several other valuation measurements.

I like median P/E because it is based on the actual reported earnings of the S&P 500 constituents and it tends to remove special accounting maneuvers.  By process, the outliers (those companies that show crazy-expensive P/Es and crazy-cheap P/Es) are eliminated.  Think of it this way, the median is the P/E that is in the middle of all the reported outcomes.

As I showed in last week’s post (here), we can look at each month’s median P/E throughout history and see what it was on any given month and what the annualized returns were 10 years later.  So simply, I believe median P/E can give us a real good sense for how well we’ll do over the coming 10 years.  Sing hallelujah or weep?

Over the last 52.1 years, the median P/E for the S&P 500 Index was 16.9.  So at 22.6, the S&P 500 index is currently 25.3% above its median fair value.  Today, based on this measure, fair value for the S&P 500 Index is at 1538.62.  I wouldn’t be surprised to see a correction that takes us to that level.  Then, we can buy more burgers and sing.

What I also like about the following chart is that it shows overvalued levels and undervalued levels.  Now the market could certainly overshoot both on the upside and on the downside, but what I like is it gives me a good sense of risk and reward.

Note the traffic sign I copied onto the chart (upper left) – red light, yellow light and green light.  The market is overvalued at 2009.29 (red light).  Note too that it ended March above that number closing the month at 2059.74.  The market is fairly valued at 1538.62 (yellow light) and extremely inexpensively priced at 1067.95 (green light).

We want to be in a position to buy all we can when the light turns green.  That won’t happen if we don’t know when to play offense and when to play defense.  During high valuation corrections, aggressive investors will get run over on the way to that opportunity, leaving themselves few resources to buy the burgers when the buying gets good.

Median P/E:


Source:  Ned Davis Research (NDR) (with stop sign and arrows added)

Warren Buffett’s favorite (as he stated in a 2001 Fortune Magazine article) valuation measure is Total Stock Market Capitalization as a Percent of GDP.

Here is how you read the next chart:  The yellow highlighted areas show the levels above which or below which the market is “very overvalued” or “very undervalued.”  The light blue arrows show the estimated value of 4,000 stocks (as calculated by NDR) in 2000 and 2016.  The light red arrows show the value of the S&P 500 stocks in 2000 and 2016.

Several takeaways:

  • both markets peaked in 2016 at higher levels than were made at the markets’ high in 2007
  • 2000 was an outlier in my view (unprecedented valuations)
  • both the 4,000 stocks and the S&P 500 are well into the “very overvalued” zone
  • better buying opportunity will be found between 50 and 60 (vertical right side of chart)


The analyst/portfolio manager, John Hussman, charts the information as follows:  using the total capitalization of the S&P 500 Index, according to his research, expect a mere 2% annualized returns over the next 10-12 years.